Question

Essay type question: What are the factors that lead to a change in the exchange rate of a currency? What are the relationships between exchange rates and (i) inflation rates and (ii) interest rates?

Answer 1

The factors which lead to change in exchange rate of a currency are as follows:

a) Inflation : If inflation rate in a particular country is low, then its product prices rises slowly. The demand for its product increases as they are cheaper. Thus currency would appreciate on account of higher demand

b) Interest rate: If a country has higher interest rate than other, money will flow into this country on account of higher interest rate to earn more. Thus demand for currency will increase and exchange rate will therefore appreciate

c) Country's Current account : A deficit in cuurent account represent higher import and lower exports. This means demand for home cuurency will be low. Thus currency would depreciate if there is current account deficit

d) Govt Debt: A country with higher govt debt is less likely to attract new capital thereby causing inflation. Foreign investor will sell bond in open market . Higher inflation leads to depreciation of currency

e) Speculation : If speculators believe that currency would appreciate in future, they will demand more of home currency causing it to appreciate on account of higher demand

f) Recession: During recession, interest rate normally falls. When interest rates fall, currency depreciates

g) Politcal Stability: Political stability gives confidence to investors thereby causing them to invest more. Currency will therefore appreciates

Relationships between exchange rates and

(i) Interest rates : If a country has higher interest rate than other, money will flow into this country on account of higher interest rate to earn more. Thus demand for currency will increase and exchange rate will therefore appreciate

(ii) Inflation: If inflation rate in a particular country is low, then its product prices rises slowly. The demand for its product increases as they are cheaper. Thus currency would appreciate on account of higher demand